What is the purpose of due diligence in Merger and Acquisition and specifically, what areas should the due diligence focus on and why?

1. What is the purpose of due diligence in Merger and Acquisition and specifically, what
areas should the due diligence focus on and why?
In order to address the purpose of due diligence in a merger and acquisition, and the areas it
should focus on, there is need to define due diligence, Merger and acquisition. There are many
definition for due diligence, merger and acquisition but for this purpose these term will be
defined as follow; Due diligence, in a merger and acquisition, is a measure of prudence, activity,
as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent person
under the particular circumstances; not measured by any absolute standard but depends on the
relative facts of the special case. In other words, to a potential acquirer, due diligence means
"making sure you get what you think you is paying for."
Merger and acquisition are defined as follows; Merger is a combination of two firms into one
with the acquirer assuming assets and liabilities of the target firm. On the other hand, acquisition
is the purchase of the stock or assets of another firm. Merger and acquisition can be achieved in
various forms. These can be through the buying of the stocks of the target company using cash or
share exchange.
The major purpose of due diligence in a merger and acquisition, includes fully understanding all
of the obligations of the company: debts, pending and potential lawsuits, leases, warranties, long-
term customer agreements, employment contracts, distribution agreements, compensation
arrangements, and so others. According to Preston (2005) due diligence process is usually
approached as a way to test the authenticity of the seller’s representations, it can also serve to
educate the buyer and the seller about the true worth of the business.
This article will focus on minimum areas which due diligence should focus on, and these
include; financial statement analysis, inventory, payroll, pension funding, market position,
customer and vendor relationships, human resources, legal liabilities, creditor relationships, and
intangible assets.
Financial Statements

2. The firm’s financial statements typically provide critical information about the financial health of
the business; however, the accuracy of the picture provided depends on whether or not the
accounting records were maintained in accordance with Generally Accepted Accounting
Principles (GAAP). If a certified public accountant audited and certified the financial statements,
the picture painted by them is probably accurate. Moreover, it is even better if one of the national
accounting firms conducted the audit (Dahl, 2004).
The first step in examining the financial statements is to determine how carefully and how long
the firm has maintained its accounting records and observed GAAP. The less rigorously GAAP
have been applied, the greater effort will be required to verify the accuracy of the financial
statements. The precision of the numbers associated with sales, inventory, payroll, travel and
business entertainment deserve particular scrutiny.
Payroll
The payroll costs of many small, private businesses require close inspection. The salary and
perquisites of the seller may be considerably higher than they would be for a comparable
professional manager. If the current owner is overcompensated, the business may be worth
significantly more on a discounted cash flow basis than current financial statements suggest.
Inventory
For many businesses, especially retailers, inventory represents a significant asset. The person
responsible for due diligence needs to verify the existence of the inventory and evaluate its
salability. Since inventory frequently changes, due diligence in this area presents a challenge.
The initial step is to determine if the amount of inventory is comparable to the amount shown on
the books. If not, the analyst needs to establish if the difference is due to ordinary fluctuations or
if there is a systematic misrepresentation. The second step consists of determining if the
inventory is salable, which can be particularly difficult for fashion-oriented businesses such as
apparel or in technology, where obsolescence is an issue.
Pension Funding

3. The due diligence effort should include an assessment of the company employee pension fund to
determine whether it is over funded or under funded. Under funding could result in a significant
unrecorded liability, while conversely an over-funded pension plan could result in significant
added value to the acquiring firm (Power, 2005). A plan is fully funded when, according to the
actuarial standards prescribed, the cumulative contributions to the pension fund are equal to the
cumulative payments expected to employees. Publicly traded companies are required to disclose
under-funding in the main body of the financial statements, however privately-held companies
do not have to meet the same standards. The key assumptions about future implicit growth rates
in the investment portfolio may be ripe for exploration. If the company uses a defined
contribution plan, however, a different set of analyses would be in order.
Intangible Assets
Intangible Assets Patents, trademarks, service marks, brand names, copyrights, trade secrets
, other intellectual property and the reputation of the firm represent intangible assets that may not
be readily apparent to the current owner (Fernandez, 2003; Rivas, 2002; Tabon, 2002). Some
assets, such as the brand name of the company’s major product and patents on manufacturing
processes, are currently creating economic value for the firm. However, some intangible assets,
such as a brand name of a discontinued product or the backlist of a publisher, may not be a
source of current value to the firm, but have the potential to generate significant economic value
in the future. In such cases, the business may be worth considerably more than a discounted cash
flow analysis would suggest.
In some cases, a rigorous analysis of the intangible assets of a firm can yield a great opportunity
to discover hidden shareholder value. However, naïve optimism in estimating the potential cash
flow could result in an erosion of shareholder value. In conducting due diligence, intangible
assets should be separated into two general asset categories. The due diligence effort should
attempt to recognize and quantify intangible assets that arise from both a contractual or other
legal right(s) and non-contractual but separable basis.
The buyer will be very interested in the extent and quality of the target company’s technology
and intellectual property.

4. Facilities and Equipment
For manufacturing organizations, facilities and equipment represent a significant proportion of
the firm’s assets. Facilities obviously include buildings and land owned by the business, but the
individual performing the due diligence analysis will need to examine and evaluate other long-
term assets as well. The buildings and land owned by a business may represent hidden value if
they have higher and better uses. Vacant land and other real estate not needed for immediate
business purposes represent assets available for liquidation after the acquisition is complete. In
all likelihood, the firm will record this real estate and similar assets on the balance sheet at a cost
that is usually less than current market value.
The firm may not employ current facilities optimally. If they are operating below capacity, the
acquiring firm may reap a benefit if sales increase. However, if production is at full capacity, the
acquiring firm may incur additional costs to accommodate any increase in sales volume. Leased
facilities should be examined for suitability and terms. For leases scheduled to expire soon, the
analyst needs to determine the conditions under which the lease will be renewed and any renewal
options. A particular concern is whether the firm is committed to any long-term leases on closed,
unprofitable, or poorly located facilities.
Ideally, the firm’s equipment will be functional, up to date, and in good operating condition. The
prospective buyer, or an expert retained for this purpose, should attempt to determine the
remaining useful economic life of the equipment. For larger companies, this analyst should
verify whether the company has a preventative maintenance program or service contracts with
manufacturers. If the firm has unused equipment, the resale or salvage value must be established.
When the analyst discovers obsolete, malfunctioning, worn out or damaged equipment, he or she
should make an estimate of replacement costs.
Customer Relationships
The market position of the firm can be a significant factor in comparing risks for companies,
whether public or private. Small market share, weak brand awareness, and limited influence with
suppliers can lower the value of a firm. Similarly, restricted access to the capital markets,

5. dependence on one or two key people, and a litany of other issues associated with size generally
contribute to the greater risk associated with privately held companies by potential investors.
This increased risk should be reflected in a lower multiple afforded to operating earnings,
earnings before interest, taxes, depreciation, and amortization, or cash flows of private firms vis-
à-vis publicly traded firms.
Businesses guard their customer lists carefully and are generally careful about the number of
their customers, the volume of business per customer, the turnover of customers and loyalty of
customers. However, any thorough due diligence process will look deeper into these issues. In a
service business, the customer list and customer loyalty represent the primary value of the firm.
Frequently, the only asset of real interest is the customer list, with an internet service provider
representing one of the extreme cases.
The due diligence effort should reveal the strength and size of the customer base. The analyst
should ascertain the firm’s effectiveness in attracting and retaining customers. If the business
extends credit to customers, the analyst will want to know about the payment history and
financial strength of the customer base. Of particular interest will be the financial stability of the
firm’s largest customer. Additionally, the due diligence analyst will be particularly eager to learn
of any impending defections of major customers. The acquiring firm needs to know if customers’
loyalty lies with the company or with the owner. In this regard, the analyst should find out about
the owner’s plans regarding starting a new business or working for a competitor. If immediate
competition from the seller is likely, the buyer should insist on a non-complete clause in the
purchase agreement.
Vendor Relationships
In certain cases, vendor relationships can be almost as important as customer relationships.
Before purchasing a business, the acquiring firm needs to discover how well key vendors have
been performing in terms of on-time delivery, product quality, return policies and willingness to
resolve problems. Since a financially weak vendor has the potential to cause serious problems for
a company, the due diligence analyst should conduct a financial analysis of important vendors
(Goldman, 2005; Oakes, 2004). According to Fulton (2003), other factors to explore include the

6. vendor’s willingness to provide favorable prices, convenient delivery schedules and generous
payment terms. Furthermore, will the sale of the firm cause vendors to renegotiate contracts or
quit supplying the firm?
Management Systems and Human Resources
Before purchasing a business, the acquiring company needs to determine the strength of the
target firm’s management team, as well as its management systems. As Melles observed (1996),
evaluating the firm’s employees during due diligence can be a delicate matter. For example, if
the analyst is too aggressive in appraising the capabilities of the firm’s management team and
other employees, morale and productivity may suffer. Even in the best of circumstances,
assessing current employees is challenging and may not always be feasible.
Depth of management
Privately held firms are frequently dependent upon a key leader, who often has personal
relationships with customers, strong ties with suppliers and typically oversees operations. As
Greengard (1999) noted, the loss of such a person after the purchase could jeopardize the
associations with existing customers, suppliers and creditors. If a bank loaned the firm money on
the strength of the owner’s vision and integrity, perhaps even requiring his personal guarantee,
the departure of the owner may threaten the credit position of the firm. This is in stark contrast to
the typical public company where there is a usually strong management team with greater size,
depth, and capabilities. Moreover, the typical publicly traded firm generally has a stronger equity
base to weather any transition.
Managerial Systems
As a starting point, the due diligence analyst should ascertain if an employee handbook or
manual exists. If there is such a manual, it should be evaluated to determine if it is complete,
clearly written, internally consistent and in compliance with employment, health and safety laws
and regulations.
The analyst should verify whether the company has systematic, written procedures for the hiring,
orientation, training, compensation, appraisal and promotion of personnel. Since most small

7. firms lack such written documents, it is a positive sign if documentation exists. Even more
impressive is if the firm actually follows its formal, written procedures. Given the complexity of
these issues, the acquiring firm should have these documents examined by an attorney who
specializes in employment law (Greengard, 1999; Kessenides, 2004).
Potential Legal Liabilities.
One of the most important tasks of the due diligence analyst is to uncover any potential legal
liabilities confronting the firm. Initially, the acquiring firm needs to ascertain if there is any
outstanding or upcoming litigation facing the target firm. While the analyst can readily find
present lawsuits in the public record, discovering potential lawsuits will require more
investigation (Kessenides,2004; Pallarito, 1995). If the firm to be purchased is a manufacturer
that used or uses chemicals extensively, the analyst should explore the possibility of a potential
hazardous waste liability. Similarly, the analyst should determine whether current or former
employees have been exposed to asbestos, mercury, benzenes or other hazardous materials
(Bennett and Bowles, 1994).
The other important area due diligence should focus is “Strategic Fit” with Buyer. The
buyer is concerned not only with the likely future performance of the target company as a stand-
alone business; it will also want to understand the extent to which the company will fit
strategically within the larger buyer organization. In strategic fit, due diligence focus on some of
these areas; will there be a strategic fit between the company and the buyer, and is the perception
of that fit based on a historical business relationship or merely on unproven future expectations?
These are some of the major areas due diligence should focus on so that understanding of the
target company is got in order to achieve synergy. Due Diligence is focused on trying to identify
and confirm the existence of synergies between the two companies. Management must know if
their expectation over synergies is real or false and about how much synergy can we expect? The
total value assigned to the synergies gives management some idea of how much of a premium
they should pay above the valuation of the Target Company. In some cases, the merger may be
called off because due diligence has uncovered substantially less synergies then what
management expected. Another important reason for due diligence is to know all of the major
risk associated with the proposed merger.

8. In conclusion Mergers and acquisitions typically involve a substantial amount of due diligence
by the buyer. Before committing to the transaction, the buyer will want to ensure that it knows
what it is buying and what obligations it is assuming, the nature and extent of the target
company’s contingent liabilities, problematic contracts, litigation risks and intellectual property
issues.
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